Chapter 1 An Overview of Corporate Finance and The Financial Environment

Transcription

1 Chapter 1 An Overview of Corporate Finance and The Financial Environment ANSWERS TO END-OF-CHAPTER QUESTIONS 1-1 a. A proprietorship, or sole proprietorship, is a business owned by one individual. A partnership exists when two or more persons associate to conduct a business. In contrast, a corporation is a legal entity created by a state. The corporation is separate and distinct from its owners and managers. b. In a limited partnership, limited partners liabilities, investment returns and control are limited, while general partners have unlimited liability and control. A limited liability partnership (LLP), sometimes called a limited liability company (LLC), combines the limited liability advantage of a corporation with the tax advantages of a partnership. A professional corporation (PC), known in some states as a professional association (PA), has most of the benefits of incorporation but the participants are not relieved of professional (malpractice) liability. c. Stockholder wealth maximization is the appropriate goal for management decisions. The risk and timing associated with expected earnings per share and cash flows are considered in order to maximize the price of the firm s common stock. d. A money market is a financial market for debt securities with maturities of less than one year (short-term). The New York money market is the world s largest. Capital markets are the financial markets for long-term debt and corporate stocks. The New York Stock Exchange is an example of a capital market. Primary markets are the markets in which newly issued securities are sold for the first time. Secondary markets are where securities are resold after initial issue in the primary market. The New York Stock Exchange is a secondary market. Mini Case: 1-1

2 e. In private markets, transactions are worked out directly between two parties and structured in any manner that appeals to them. Bank loans and private placements of debt with insurance companies are examples of private market transactions. In public markets, standardized contracts are traded on organized exchanges. Securities that are issued in public markets, such as common stock and corporate bonds, are ultimately held by a large number of individuals. Private market securities are more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization. Derivatives are claims whose value depends on what happens to the value of some other asset. Futures and options are two important types of derivatives, and their values depend on what happens to the prices of other assets, say IBM stock, Japanese yen, or pork bellies. Therefore, the value of a derivative security is derived from the value of an underlying real asset. f. An investment banker is a middleman between businesses and savers. Investment banking houses assist in the design of corporate securities and then sell them to savers (investors) in the primary markets. Financial service corporations offer a wide range of financial services such as brokerage operations, insurance, and commercial banking. A financial intermediary buys securities with funds that it obtains by issuing its own securities. An example is a common stock mutual fund that buys common stocks with funds obtained by issuing shares in the mutual fund. g. A mutual fund is a corporation that sells shares in the fund and uses the proceeds to buy stocks, long-term bonds, or short-term debt instruments. The resulting dividends, interest, and capital gains are distributed to the fund s shareholders after the deduction of operating expenses. Different funds are designed to meet different objectives. Money market funds are mutual funds which invest in short-term debt instruments and offer their shareholders check writing privileges; thus, they are essentially interest-bearing checking accounts. h. Physical location exchanges, such as the New York Stock Exchange, facilitate communication between buyers and sellers of securities. Each physical location exchange is a physical entity at a particular location and is governed by an elected board of governors. A computer/telephone network, such as Nasdaq, consists of all the facilities that provide for security transactions not conducted at a physical location exchange. These facilities are, basically, the communications network that links the buyers and sellers. i. An open outcry auction is a method of matching buyers and sellers. In an auction, the buyers and sellers are face-to-face, with each stating the prices and which they will buy or sell. In a dealer market, a dealer holds an inventory of the security and makes a market by offering to buy or sell. Others who wish to buy or sell can see the offers made by the dealers, and can contact the dealer of their choice to arrange a transaction. In an ECN, orders from potential buyers and sellers are automatically matched, and the transaction is automatically completed. Mini Case: 1-2

3 j. Production opportunities are the returns available within an economy from investment in productive assets. The higher the production opportunities, the more producers would be willing to pay for required capital. Consumption time preferences refer to the preferred pattern of consumption. Consumer s time preferences for consumption establish how much consumption they are willing to defer, and hence save, at different levels of interest. k. The real risk-free rate is that interest rate which equalizes the aggregate supply of, and demand for, riskless securities in an economy with zero inflation. The real risk-free rate could also be called the pure rate of interest since it is the rate of interest that would exist on very short-term, default-free U.S. Treasury securities if the expected rate of inflation were zero. It has been estimated that this rate of interest, denoted by r*, has fluctuated in recent years in the United States in the range of 2 to 4 percent. The nominal risk-free rate of interest, denoted by r RF, is the real risk-free rate plus a premium for expected inflation. The shortterm nominal risk-free rate is usually approximated by the U.S. Treasury bill rate, while the long-term nominal risk-free rate is approximated by the rate on U.S. Treasury bonds. Note that while T- bonds are free of default and liquidity risks, they are subject to risks due to changes in the general level of interest rates. l. The inflation premium is the premium added to the real risk-free rate of interest to compensate for the expected loss of purchasing power. The inflation premium is the average rate of inflation expected over the life of the security. Default risk is the risk that a borrower will not pay the interest and/or principal on a loan as they become due. Thus, a default risk premium (DRP) is added to the real risk-free rate to compensate investors for bearing default risk. Liquidity refers to a firm s cash and marketable securities position, and to its ability to meet maturing obligations. A liquid asset is any asset that can be quickly sold and converted to cash at its fair value. Active markets provide liquidity. A liquidity premium is added to the real risk-free rate of interest, in addition to other premiums, if a security is not liquid. m. Interest rate risk arises from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capital loss, and the longer the term to maturity, the larger the loss. Thus, a maturity risk premium must be added to the real risk-free rate of interest to compensate for interest rate risk. Reinvestment rate risk occurs when a short-term debt security must be rolled over. If interest rates have fallen, the reinvestment of principal will be at a lower rate, with correspondingly lower interest payments and ending value. Note that long-term debt securities also have some reinvestment rate risk because their interest payments have to be reinvested at prevailing rates. Mini Case: 1-3

4 n. The term structure of interest rates is the relationship between yield to maturity and term to maturity for bonds of a single risk class. The yield curve is the curve that results when yield to maturity is plotted on the Y axis with term to maturity on the X axis. o. When the yield curve slopes upward, it is said to be normal, because it is like this most of the time. Conversely, a downwardsloping yield curve is termed abnormal or inverted. p. The expectations theory states that the slope of the yield curve depends on expectations about future inflation rates and interest rates. Thus, if the annual rate of inflation and future interest rates are expected to increase, the yield curve will be upward sloping, whereas the curve will be downward sloping if the annual rates are expected to decrease. r. A foreign trade deficit occurs when businesses and individuals in the U. S. import more goods from foreign countries than are exported. Trade deficits must be financed, and the main source of financing is debt. Therefore, as the trade deficit increases, the debt financing increases, driving up interest rates. U. S. interest rates must be competitive with foreign interest rates; if the Federal Reserve attempts to set interest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasing bond prices, resulting in higher U. S. rates. Thus, if the trade deficit is large relative to the size of the overall economy, it may hinder the Fed s ability to combat a recession by lowering interest rates Sole proprietorship, partnership, and corporation are the three principal forms of business organization. The advantages of the first two include the ease and low cost of formation. The advantages of the corporation include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) requirements to file state and federal reports for registration, which are expensive, complex and time-consuming. 1-3 The three primary determinants of a firm s cash flows are: (1) sales revenues; (2) operating expenses, such as raw materials costs and labor costs; and (3) the necessary investments in operating capital, such as buildings, equipment, and inventory. 1-4 Financial intermediaries are business organizations that receive funds in one form and repackage them for the use of those who need funds. Through financial intermediation, resources are allocated more effectively, and the real output of the economy is thereby increased. Mini Case: 1-4

5 1-5 Short-term rates are more volatile because (1) the Fed operates mainly in the short-term sector, hence Federal Reserve intervention has its major effect here, and (2) long-term rates reflect the average expected inflation rate over the next 20 to 30 years, and this average does not change as radically as year-to-year expectations. 1-6 a. If transfers between the two markets are costly, interest rates would be different in the two areas. Area Y, with the relatively young population, would have less in savings accumulation and stronger loan demand. Area O, with the relatively old population, would have more savings accumulation and weaker loan demand as the members of the older population have already purchased their houses and are less consumption oriented. Thus, supply/demand equilibrium would be at a higher rate of interest in Area Y. b. Yes. Nationwide branching, and so forth, would reduce the cost of financial transfers between the areas. Thus, funds would flow from Area O with excess relative supply to Area Y with excess relative demand. This flow would increase the interest rate in Area O and decrease the interest rate in Y until the rates were roughly equal, the difference being the transfer cost. 1-7 a. The immediate effect on the yield curve would be to lower interest rates in the short-term end of the market, since the Fed deals primarily in that market segment. However, people would expect higher future inflation, which would raise long-term rates. The result would be a much steeper yield curve. b. If the policy is maintained, the expanded money supply will result in increased rates of inflation and increased inflationary expectations. This will cause investors to increase the inflation premium on all debt securities, and the entire yield curve would rise; that is, all rates would be higher. 1-8 a. S&Ls would have a higher level of net income with a normal yield curve. In this situation their liabilities (deposits), which are short-term, would have a lower cost than the returns being generated by their assets (mortgages), which are long-term. Thus they would have a positive spread. b. It depends on the situation. A sharp increase in inflation would increase interest rates along the entire yield curve. If the increase were large, short-term interest rates might be boosted above the long-term interest rates that prevailed prior to the inflation increase. Then, since the bulk of the fixed-rate mortgages were initiated when interest rates were lower, the deposits (liabilities) of the S&Ls would cost more than the return being provided on the assets. If this situation continued for any length of time, the equity (reserves) of the S&Ls would be drained to the point that only a bailout would prevent bankruptcy. This has indeed happened in the United States. Thus, in this situation the S&L industry would be better off selling their mortgages to federal agencies and collecting servicing fees rather than holding the mortgages they Mini Case: 1-5

6 originated. SOLUTIONS TO END-OF-CHAPTER PROBLEMS 1-1 r* = 3%; I 1 = 2%; I 2 = 4%; I 3 = 4%; MRP = 0; r T-2 =?; r T-3 =? r = r* + IP + DRP + LP + MRP. Since these are Treasury securities, DRP = LP = 0. r T-2 = r* + IP 2 IP 2 = (2% + 4%)/2 = 3% r T-2 = 3% + 3% = 6%. r T-3 = r* + IP 3 IP 3 = (2% + 4% + 4%)/3 = 3.33% r T-3 = 3% % = 6.33%. 1-2 r T-10 = 6%; r C-10 = 8%; LP = 0.5%; DRP =? r = r* + IP + DRP + LP + MRP. r T-10 = 6% = r* + IP + MRP; DRP = LP = 0. r C-10 = 8% = r* + IP + DRP + 0.5% + MRP. Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both bonds are equal. The only difference between them is the liquidity and default risk premiums. r C-10 = 8% = r* + IP + MRP + 0.5% + DRP. But we know from above that r* + IP + MRP = 6%; therefore, r C-10 = 8% = 6% + 0.5% + DRP 1.5% = DRP. 1-3 r T-1, 1 = 5%; r T-1, 2 = 6%; r T-2 =? r T-2 = 5% + 6% 2 = 5.5%. 1-4 r* = 3%; IP = 3%; r T-2 = 6.2%; MRP 2 =? r T-2 = k* + IP + MRP = 6.2% r T-2 = 3% + 3% + MRP = 6.2% MRP = 0.2%. Mini Case: 1-6

7 1-5 Let x equal the yield on 1-year securities 1 year from now: (5.6% + x)/2 = 6% 5.6% + x = 12% x = 6.4%. 1-6 Let x equal the yield on 2-year securities 4 years from now: 7.5% = [(4)(7%) + 2x]/ = x x = or 8.5%. 1-7 r = r* + IP + MRP + DRP + LP. r* = IP = [ (5)(0.035)]/7 = MRP = (6) = DRP = 0. LP = 0. r = = = 6.8%. Mini Case: 1-7

8 1-8 a. r 1 = 3%, and r 2 = 3% + r 1 in Year 2 = 4.5%, 2 Solving for r 1 in Year 2, we obtain r 1 in Year 2 = (4.5% x 2) - 3% = 6%. b. For riskless bonds under the expectations theory, the interest rate for a bond of any maturity is r n = r* + average inflation over n years. If r* = 1%, we can solve for IP n : Year 1: r 1 = 1% + I 1 = 3%; I 1 = expected inflation = 3% - 1% = 2%. Year 2: r 1 = 1% + I 2 = 6%; I 2 = expected inflation = 6% - 1% = 5%. Note also that the average inflation rate is (2% + 5%)/2 = 3.5%, which, when added to r* = 1%, produces the yield on a 2-year bond, 4.5%. Therefore, all of our results are consistent. Alternative solution: Solve for the inflation rates in Year 1 and Year 2 first: r RF = r* + IP Year 1: 3% = 1% + IP 1 ; IP 1 = 2%, thus I 1 = 2%. Year 2: 4.5% = 1% + IP 2 ; IP 2 = 3.5%. IP 2 = (I 1 + I 2 )/2 3.5% = (2% + I 2 )/2 I 2 = 5%. Then solve for the yield on the one-year bond in the second year: Year 2: r 1 = 1% + 5% = 6%. Mini Case: 1-8

9 1-9 r* = 2%; MRP = 0%. r 1 = 5%; r 2 = 7%. r 2 = 7% = r + r1 in Year 2 2 1, 5% + r 1 in Year 2, 2 9% = r 1 in Year 2. r 1 in Year 2 = r* + I 2, 9% = 2% + I 2 7% = I 2. The average interest rate during the 2-year period differs from the 1- year interest rate expected for Year 2 because of the inflation rate reflected in the two interest rates. The inflation rate reflected in the interest rate on any security is the average rate of inflation expected over the security s life First, note that we will use the equation r t = 3% + IP t + MRP t. We have the data needed to find the IPs: IP 5 = 8% + 5% + 4% + 4% + 4% 5 25% = = 5%. 5 IP 2 = 8% + 2 5% = 6.5%. Now we can substitute into the equation: r 2 = 3% + 6.5% + MRP 2 = 10%. r 5 = 3% + 5% + MRP 5 = 10%. Now we can solve for the MRPs, and find the difference: MRP 5 = 10% - 8% = 2%. MRP 2 = 10% - 9.5% = 0.5%. Difference = (2% - 0.5%) = 1.5%. Mini Case: 1-9

10 1-11 Basic relevant equations: r t = r* + IP t + DRP t + MRP t + LP t. But here IP is the only premium, so r t = r* + IP t. IP t = Avg. inflation = (I 1 + I )/N. We know that I 1 = IP 1 = 3% and r* = 2%. Therefore, r 1 = 2% + 3% = 5%. r 3 = r 1 + 2% = 5% + 2% = 7%. But, r 3 = r* + IP 3 = 2% + IP 3 = 7%, so IP 3 = 7% - 2% = 5%. We also know that I t = Constant after t = 1. We can set up this table: r* I Avg. I = IP t r = r* + IP t %/1 = 3% 5% 2 2 I (3% + I)/2 = IP I (3% + I + I)/3 = IP 3 r 3 = 7%, so IP 3 = 7% - 2% = 5%. Avg. I = IP 3 = (3% + 2I)/3 = 5% 2I = 12% I = 6%. Mini Case: 1-10

11 1-12 a. Real Years to Risk-Free Maturity Rate (r*) IP** MRP r T = r* + IP + MRP 1 2% 7.00% 0.2% 9.20% **The computation of the inflation premium is as follows: Expected Average Year Inflation Expected Inflation 1 7% 7.00% For example, the calculation for 3 years is as follows: 7% + 5% + 3% = 5.00%. 3 Thus, the yield curve would be as follows: Mini Case: 1-11

12 Interest Rate (%) LILCO Exxon T-bonds Years to Maturity b. The interest rate on the Exxon bonds has the same components as the Treasury securities, except that the Exxon bonds have default risk, so a default risk premium must be included. Therefore, r Exxon = r* + IP + MRP + DRP. For a strong company such as Exxon, the default risk premium is virtually zero for short-term bonds. However, as time to maturity increases, the probability of default, although still small, is sufficient to warrant a default premium. Thus, the yield risk curve for the Exxon bonds will rise above the yield curve for the Treasury securities. In the graph, the default risk premium was assumed to be 1.0 percentage point on the 20-year Exxon bonds. The return should equal 6.3% + 1% = 7.3%. c. LILCO bonds would have significantly more default risk than either Treasury securities or Exxon bonds, and the risk of default would increase over time due to possible financial deterioration. In this example, the default risk premium was assumed to be 1.0 percentage point on the 1-year LILCO bonds and 2.0 percentage points on the 20-year bonds. The 20-year return should equal 6.3% + 2% = 8.3%. Mini Case: 1-12